Cases Update - May 2017

This case emphasises the importance of taking all potential scenarios (including, in this case, the early and unexpected death of a shareholder) into account when drafting exit and valuation provisions for a shareholders’ agreement for a start-up company that may take a few years to generate value.   

ILS Rehab Pty Ltd (Company) had 3 directors who also each held one share in the Company.  When one of the directors (Mr Borg) died on 6 March 2015, a dispute arose as to the construction of the provisions in the shareholders’ agreement relating to the price to be paid by the surviving shareholders for Mr Borg’s share. 

The shareholders’ agreement provided as follows:

  • clause 13.1 - If a Director should die during the Shareholding Period, then the Shareholders that are not the Respective Shareholders of that Director shall purchase the shares held by the Respective Shareholder of that Director (‘the outgoing Shareholder’);
  • clause 13.1.1 - The purchase price shall be equal to 3 x EBITDA; and
  • clause 1.1 – EBITDA was relevantly defined as “the earnings before interest, tax, depreciation and amortisation of the Company in the immediately preceding financial year, excluding any unusual or non-recurring items.

White J in the Supreme Court of New South Wales firstly ordered rectification of clause 13.1.1 to read: The purchase price shall be equal to the percentage shareholding of the outgoing Shareholder in the Company multiplied by 3 x EBITDA.

The key question was then whether the reference in the definition of EBITDA to “immediately preceding financial year’ was to the financial year immediately preceding the death of Mr Borg (in which case the purchase price would be nil or only nominal consideration as EBITDA in that year was negative), or the financial year immediately preceding the time for completion of the purchase of Mr Borg’s share under clause 13.1.

White J found that it was the date of death that determines which financial year is the immediately preceding financial year, and that the purchase price for Mr Borg’s was therefore only nominal.  White J rejected the argument that if the event of death was the trigger date (as opposed to the date on which a notice of sale was given under the general sale process for shareholders wishing to sell shares under the shareholders’ agreement), there would be no contractual mechanism to determine when the purchase was to take place, finding that:

  • in circumstances where no time is fixed, then it is to be implied that it is to be done within a reasonable time; and
  • if such construction was correct, Mr Borg’s administrator could, but is not required to give a notice that she had decided to sell Mr Borg’s share.  However, the clear intent of clause 13 is that purchase of Mr Borg’s share by the surviving shareholders is mandatory given the clause states that the surviving shareholders “shall purchase” Mr Borg’s share.

White J was not persuaded by the complaint that this caused hardship because the Company was a start-up that was only just becoming profitable.  Rather, White J emphasised that the parties had contracted for relative certainty (as opposed to applying a potentially complex valuation exercise if the goodwill or future prospects of the Company were to be taken into account) and Mr Borg’s administrators did not rely upon hardship as a separate defence to a claim for specific performance (nor was there evidence that would support any such defence).

Unauthorised transactions in breach of a director’s statutory and general law duties: In the matter of FAL Healthy Beverages Pty Ltd and FAL Retail Pty Ltd [2017] NSWSC 476

The Supreme Court of New South Wales has provided some valuable insights into the nature, content and relevant parameters of the duties of directors under sections 180, 181 and 182 of the Corporations Act 2001 (Cth) (Act) (and the corresponding general law duties), as well as shareholder ratification as a defence to a claim for breach of duty.

FAL Healthy Beverages Pty Ltd (FAL HB) and its subsidiary FAL Retail Pty Ltd (FAL Retail) brought proceedings against Mr Tim Xenos for breach of statutory duties under the Act and fiduciary duties in connection with several unauthorised transactions which benefited him financially. 

Mr Xenos was the director (for some periods by formal appointment and for some periods as a de-facto director) and chief executive officer of both FAL HB and FAL Retail and held a 2.5% share in FAL HB.  At the time of his appointment as chief executive officer and for a considerable time thereafter, Mr Xenos was an undischarged bankrupt and was prohibited from managing FAL HB and FAL Retail under section 206B of the Act.

Black J in the Supreme Court of New South Wales held that on the evidence, Mr Xenos had, in breach of his duties, caused FAL HB (and in some cases, FAL Retail) to make unauthorised payments to:

  • a company controlled by Mr Xenos and another company with which Mr Xenos was pursuing other business opportunities;
  • the NSW Office of State Revenue for speeding and other fines in relation to Mr Xenos’ car; and
  • a law firm for fees in connection with ‘commercial matters relating to FAL HB’ which, to the contrary, pertained to advice relating to Mr Xenos’ bankruptcy.

The evidence also showed that Mr Xenos was the sole signatory on all of FAL HB and FAL Retail’s bank accounts and that he authorised payments through the NAB Connect platform and in some cases, generated false or at least misleading invoices. 

In finding that Mr Xenos had breached his duties under section 180 (to exercise care and diligence), section 181 (to exercise his powers and discharge his duties in good faith in the best interests of FAI HB and FAL Retail and for a proper purpose) and section 182 (to not improperly use this position to gain an advantage for himself or someone else, or cause detriment to FAL HB or FAL Retail) of the Act, and his corresponding general law duties, Black J observed that:

  • Mr Xenos’ contention that FAL HB and FAL Retail had not made out their case due to an absence of adequate documentary support for the impugned transactions was unfounded.  Rather, as a director and officer, Mr Xenos was obliged under section 286(1) of the Act to keep (or cause to be kept) written financial records that accurately record and explain transactions and the financial position and performance of the companies, and that would enable true and fair financial statements to be prepared and audited;
  • it was not essential for FAL HB and FAL Retail to prove that Mr Xenos directly conducted the transactions himself.  Rather, the breach of duty is made out if he otherwise procured, permitted or authorised the payments (through requesting the payments or submitting false invoices to the accounting staff) or if he knew that the payments were to be or had been made and did nothing to stop or return those payments.  It would be sufficient to establish a breach of section 180 if Mr Xenos allowed procedures to subsist which permitted the relevant payments to him and interests associated with him, and sufficient to establish a breach of sections 181 and 182 if he allowed such payments to be made for an improper purpose or to FAL HB’s detriment, whether or not he personally made them; and
  • Mr Xenos could not avoid liability due to the principles of ratification and acquiescence on the basis of his contention that the various transactions were approved by FAL Holdings Arabia Co Ltd as the majority shareholder of FAI HB, and Mr Xenos himself as a minority shareholder. In this regard, Black J found that: 
    • to the extent that ratification may narrow a duty owed to shareholders so as to be relevant to determining whether a breach of a statutory duty has been established, that will be limited by a requirement of disclosure, and possibly also by public interest  considerations; and
    • in any event, in the case of the general law duties, a ratification of, or unanimous consent to, Mr Xenos’ conduct could only be established by prior approval or subsequent ratification of the transactions by FAL HB’s shareholders with full disclosure of all material circumstances, including the character of the transactions and the nature of the relevant conflict. 
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